Penny Stock Trading
With the markets trading at record levels and stocks considered to be significantly overvalued, it’s becoming more and more difficult to find great stocks with tremendous upside potential. That might be why penny stock trading is becoming a popular alternative to small-, medium-, and large-cap stocks.
The allure to penny stocks is obvious: they can make investors a lot of money, something sorely lacking in this climate. With the geriatric, long-in-the-tooth bull market lumbering along, investors are on the lookout for equities that seriously outpace the broader markets.
Advertisement
It’s been tough to do with larger stocks lately. Stocks may have experienced a huge bump after Donald Trump won the presidential election in November, and the Dow Jones Industrial Average (DJIA) may have breached the 20,000 level, but stocks have been trading in a tight range since the middle of December. That’s because there’s nothing to propel them higher.
With stocks (according to the Case-Shiller CAPE ratio) overvalued by 76%, investors are taking a breather, waiting to see whether President Trump’s economic policies can boost corporate America’s anemic earnings.
With Wall Street offering little in the way of growth, investors have turned to penny stocks. While there is a lot of potential to make money with penny stocks, there is greater potential to lose everything with penny stocks. That’s because only a sliver of all penny stocks are worth investing in. The rest are garbage.
That’s why investing in penny stocks is different from investing in mid- and large-cap stocks. Investing in penny stocks isn’t necessarily any riskier than investing in other stocks (there are no certainties when it comes to investing) but it’s certainly a lot more difficult to conduct due diligence. Many penny stocks are small companies with little to no analyst coverage.
Moreover, while a small percentage of penny stocks trade on the Nasdaq and NYSE, the vast majority are over-the-counter stocks, and as a result, are not subject to the same regulations as the major, legitimate exchanges. Penny stocks that trade on the Pink Sheets don’t need to disclose much of anything, so it can be difficult to trust anything you read, if you can actually find anything to read.
On top of that, because penny stocks are generally smaller companies, they are thinly traded, volatile, susceptible to manipulation, easy to get into, and in some cases, difficult to exit.
There are obviously some investing traits that are the same with penny stocks as large-cap stocks, but understanding what makes penny stocks unique will help increase your knowledge of penny stocks, make more profitable trades, and avoid making costly mistakes.
If you’re wondering how to trade penny stocks, below are 10 rules to penny stock investing that will help you trade more confidently and achieve better returns.
#1. Due Diligence
No one likes doing homework. But when it comes to investing your hard-earned money, there are no short cuts. That’s because there are no sure bets when it comes to investing; penny stocks or otherwise (it doesn’t matter if you lost money in Bre-X or Enron, you still lost money).
Besides, the more you know about a penny stock, the fundamentals and technicals, the more you understand what you’re investing in. Does it have a good cash position? What about debt? Are revenues and earnings going up? Does it provide a dividend?
Some fundamentals are more important to others when it comes to penny stocks. Not paying a dividend isn’t a big deal, bleeding cash is. This will help you determine the strengths and weaknesses, whether you think it’s overvalued or undervalued, about short- and long-term potential, and entry and exit points.
#2. Ignore Penny Stock Tips…At All Costs
Stock tips in general should be avoided. Even the ones you get at the office cooler. Chances are really, really good that by the time you hear about it, even if it is legitimate, the chances to make any money are gone. What is possible, though, is that you could lose all your money when the share price retraces.
If you love penny stocks, ignore all the hot tips you get from an unsolicited e-mail. Why would someone send you an anonymous, unsolicited tip to make money on a penny stock? I wouldn’t. If I found a great penny stock, I’d keep it to myself.
Of all the unsolicited e-mails I’ve received touting the next 10-bagger, 100% of them have been garbage. A cursory look at their fundamentals shows the penny stock has no cash, no revenue, no earnings, lots of debt, and no potential. Even the disclaimer at the bottom shows the author of the e-mail was paid in cash or shares of the company to promote the penny stock. Still, investors pour millions of dollars into these pump-and-dump schemes, enriching everyone but investors.
#3. Pay Attention to Technicals
Admittedly, penny stocks are not great when it comes to technicals. Again, penny stocks are generally thinly traded and volatile. A technical indicator that would point to an entry level with a large-cap stock might be a moot point when it comes to penny stocks.
But there are some things you can keep an eye out for that may not make you a lot of money, but will save you a lot instead.
If you find the chart of a penny stock that has been trading with low volume and in a tight range for months on end but then starts to climb on huge volume, find out why. If the company announced solid earnings or a new agreement, pay attention.
If there’s no corporate news of substance, it’s most likely a newsletter pump-and-dump, which is different than an unsolicited e-mail scam. This is a much more sophisticated way to promote a worthless penny stock. Instead of a single e-mail, a newsletter can be mailed to hundreds of thousands of investors over a period of a month or two. The first intrigued group buys in, and a couple of weeks later, the second group sees volume and price appreciation, and also jumps in. The third wave of newsletter recipients sees some real action, deduces the penny stock is the real deal, and sends the price even higher. Once the mail campaign is gone, interest evaporates, volume dries up, and investors flee. The only people that made money are those that paid for the newsletter.
#4. Buy Low, Sell High, But Don’t Get Greedy
Investors love penny stocks because of the potential for huge gains. The 10% gain that would make a large-cap investor pleased wouldn’t even be worth mentioning to penny stock investors. They’re looking for triple-digit gains. And some will hold out for that no matter what. This could be a mistake.
Yes, the whole point of investing in penny stocks is to make money. But it’s easy to get greedy after seeing a stock rise 100%. After all, if a stock can double from $0.50 to $1.00, what’s to say it won’t hit $2.00?
A lot.
If the penny stock has reached or surpassed your target price, you might want to consider taking profits, or leaving some on the table if you think the company has more potential. Just keep in mind, penny stocks can be volatile, and the share price can rise and fall quickly. If the share price starts to fall, your profits can quickly turn into a loss.
There’s no shame in selling a penny stock and taking a 50% gain. Holding out for a 50% loss on the other hand…
#5. Don’t Fall in Love with a Penny Stock
You find a decent penny stock, spend hours checking out the fundamentals and pouring over the technicals, and eureka, you think it’s undervalued! You take a position and a few weeks later, the share price starts to fall. Instead of selling, though, you hang on, believing it will rebound. It might, it might not. Be detached and objective. It’s better to have an affair with a penny stock and sell it when it disappoints, free up capital, and put it to better use elsewhere.
#6. Know When to Fold
Even country crooner Kenny Rogers knows you’ve got to know when to fold ‘em. Investing in penny stocks shouldn’t be a gamble. If you’ve conducted thorough due diligence, you’ll know when to get in and when to sell. Before you buy a penny stock, decide what your profit/loss is going to be. And stick to it. Holding on to a penny stock, hoping it will claw its way back up so you can break even, could be an effort in futility. Know when to admit defeat and sell.
#7. Use Stop Orders
The share price of a penny stock can rise and fall quickly. If you don’t have the time to sit and watch your portfolio on a regular basis, the best way to protect yourself from losses and take advantage of a dip is with a stop order. A stop order is an order to sell or buy a penny stock once the price of the penny stock reaches a specified price. A stop order is the easiest way to limit a loss or protect a profit.
#8. You Can’t David Copperfield the Markets
Every investor knows that the markets move in cycles. Every bull market eventually comes to an end, stocks crash or correct, a bear market ensues, a cycle of growth emerges, and stocks hit new record levels. Boom, bust, echo.
Knowing how the markets move is not the same as knowing when the markets are going to hit a top or bottom. The fact is, no one can accurately time the market. Trying to predict the single, solitary, perfect moment to buy or sell a penny stock will just lead to more stress and second guessing, which ends up with more losses than gains.
If you want to maximize your profits, put the Criss Angel book of magic away and instead, gain a full understanding of the penny stock in question, and wait for what you believe is a good entry and exit point. This will increase your odds of profiting and minimize the risk of loss more than the wisdom of Doug Henning.
#9. Buy Damaged Penny Stocks Not Damaged Companies
When the stock market tanked in 2008, a lot of excellent small- and mid-cap stocks dropped into penny stock territory. Some became penny stocks because their weak fundamentals came to light and they deserved the correction. Other companies became penny stocks because of broader market conditions and presented investors with great opportunities.
Case in point, in 2008, the Ford Motor Company (NYSE:F) share price crashed, along with the rest of the market, tumbling from over $6.00 per share in early 2008 to $0.98 in November. Ford did not have the same kind of money problems the other car makers did, it had stable operations, and a multi-billion market cap.
Ford became a penny stock due to sector weakness, not because of internal problems or scandals. Thanks to new fuel-efficient vehicles and an improving economy, Ford’s share price rebounded. By early 2011, Ford’s share price had advanced 1,400% to around $15.55.
Ford isn’t a typical penny stock company, but it does show how a well-run stock trading for under $5.00 can reward investors when it’s damaged because of external forces.
On the other hand, there were a lot of stocks that were damaged because of their operations and weak cash position, which led to further sell-offs. Some resurfaced, some mercifully didn’t.
#10. Don’t Average Down
Because penny stocks are relatively cheap compared to mid- and large-cap stocks, investors have a tendency to gloss over how much they have invested in a company. And if the share price starts to tank, it can be easy to justify staying in the losing position. For some, it makes sense to stay in a penny stock that has fallen from $2.50 to $1.75 than a stock that has slipped from $30.00 to $25.00. There’s less to lose with the former. Of course, this is pure folly, because in both cases, if you stay in the losing position too long, you could end up losing everything.
Regardless, some penny stock investors hang on to the losing position and instead of selling, average down to help absorb the loss. Averaging down is when you purchase additional shares of a penny stock after the price has fallen, lowering the average purchase price.
This strategy can work if the share price rebounds of course, but if the price falls even further, you’re stuck with a huge losing position. Instead of losing $5,000 with an average share price of $1.00, you take solace knowing you lost $5,000 with an average share price of $0.25. Either way you still lose. Everything.
